Seller financing is when the owner of a property sells their property, but at least some portion of the purchase price is paid by the buyer in the future rather than at the time of the sale. A typical arrangement is the buyer pays a down payment at the time of sale, and the rest of the cost is paid back over some period of time, usually with interest.
The advantage to the buyer is they can buy a property without paying in full for it upfront, and with terms that may be more favorable to them than those that may be available to that particular buyer at a bank. The advantages to the seller are that they may be able to sell to a wider selection of buyers, possibly at a higher sale price, plus the benefit of earning interest.
But they also get a significant tax advantage in that their capital gains on the property can be spread out over multiple tax years. This is called an installment sale. But not all seller financing arrangements qualify for installment sale treatment.
Qualifications for an Installment Sale
Installment sales are defined in section 453 of the tax code, and the law imposes a number of restrictions on situations in which it can be used.
- At least one payment is made in a later tax year than the original sale date.
- The sale results in a taxable gain, it can’t be a sale at a loss.
- It doesn’t apply to the sale of inventory, which means it can’t be used if you’re selling a property as a real estate dealer or a flipper. But it can apply to a sale of your personal home or vacation home, or to the sale of a rental property.
- It isn’t applicable to trading of stocks or securities.
- Installment sale treatment is the default treatment for qualifying transactions. But the installment sale treatment is optional, you can elect out of it simply by reporting the capital gains all in the year of sale and omitting form 6252. But this opt-out election is only possible if you file the return by the extended deadline. And if you elect out of installment sale treatment, you can’t change your choice of treatment by later amending the return if it’s after the final deadline for that tax year, according to tax code section 453(d).
- Additional restrictions apply to sales to related persons, under tax code section 453(e). “Related persons” is defined as “brothers and sisters (whether by the whole or half blood), spouse, ancestors, and lineal descendants”, or individuals with at least a partial ownership interest in the property.
Deferment of Capital Gains
If your sale qualifies as an installment sale, the advantage is that your capital gains can be spread out over the time the buyer is making payments on the property. That can be a major tax advantage because that means not only do you not have to pay the tax as soon, but also spreading it out over multiple years could also result in the income being taxed in a lower tax bracket.
When using the installment method, you only pay capital gains tax on the prorated portion of the principal that the buyer pays for each tax year. So if their down payment and other payments the first year covers 30% of the purchase price, then you’ll report and pay tax on 30% of the capital gains tax that year. A portion of each payment the buyer makes is attributed to a payment towards your basis (which is not taxable), and the capital gains portion (which is taxable). This is reported on form 6252, which results in a calculation that flows to Schedule D and/or form 4797 of the tax return.
While capital gains are spread out over time, depreciation recapture is still fully taxable in the year of the sale. That only applies to recapture of section 1245 property with depreciation that is in excess of straight-line depreciation, so this doesn’t include section 1250 unrecaptured gain. In other words, recapture of regular depreciation of the building over 27.5 years or 39 years isn’t taxable in the year of sale, that can be spread out over the installment sale payments. But recapture of depreciation for other types of property, such as appliances and furniture that are depreciated faster, is taxable in the year of sale. This means that you may have more taxable income in the year of sale if you did a cost segregation study on the property, which shifts some portions of the property from 1250 to 1245 classified assets.
An installment sale may be combined with a 1031 exchange or section 121 home sale exclusion.
If you have installment obligations totaling more than $5 million at the end of a tax year, you may additionally have to pay interest on capital gains tax that was deferred using the installment sale method.
Interest Payments
Interest you receive is reported on Schedule B of your tax return and it is taxed at your ordinary income tax rate. And you do have to charge a reasonable amount of interest. If you charge too little, the IRS may recharacterize part of your principal payments on the property as interest (which is taxed at a higher tax rate as ordinary income than the capital gains tax rate of the principal). The portion payments on the property that you report as interest should at least be equivalent or greater than the applicable federal rate.
If you sell the property to a buyer who uses the property as their personal residence, you must report their name, address, and social security number on your Schedule B. And if the buyer is claiming an itemized deduction for their interest payments, they must report your name, address, and social security number on their Schedule A.
For additional information see IRS tax topic 705, Installment Sales and Publication 537, Installment Sales.
